A Good Time to Play the Volatility Game

by Tyler Craig | October 23, 2012 11:45 am

The latest setback to Mr. Market came on the heels of poor earnings from some heavy hitters in the Dow Jones Industrial Average. DuPont (NYSE:DD[1]), 3M (NYSE:MMM[2]) and United Technologies (NYSE:UTX[3]) were the latest victims in what’s turning out to be quite the disappointing Q3 earnings season. The trio of misses led to the Dow gapping down over 1% at today’s open.

From a charting perspective, today’s down-gap is particularly worrisome as it completely negated yesterday’s late-day rally. The trapped bulls from yesterday will likely panic out of their positions, further propelling today’s plunge.

The market action of late reveals the treacherous nature of earnings season amid a shaky market — gaps and traps abound.

Fortunately, traders disenchanted with the stock-pickers’ game have a few alternatives to consider. Instead of making a bet on direction, how about making a bet on volatility?

The IPATH S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[4]) allows traders to wager on the CBOE Volatility Index (CBOE:VIX[5]) as well as the term structure of VIX futures.

Click to EnlargeIn light of the recent super-spike in the VIX — it’s up 30% since Friday’s open — the VXX has staged a countertrend rally toward its declining 50-day moving average. Once the current market downdraft terminates and a new up-leg takes hold, the VXX should resume its downward spiral. The current rise in VXX may be setting up a low-risk entry point for bearish positions.

As far as timing your entry I would suggest waiting until we see some signs that the deluge of selling in the market is abating. Occasionally, we see VIX spikes get a bit ridiculous to the upside, but with the fear gauge already up 17% on the day and notably above the upper Bollinger band, I think it’s appropriate to begin to look for some contrarian plays here.

One limited-risk spread worth considering is the bear put spread. Also called a vertical debit spread, the position is constructed by buying a higher-strike put and selling a lower-strike put in the same expiration month. The risk is limited to the initial debit, while the reward is limited to the distance between strike prices minus the initial debit.

Traders anticipating the VXX will resume its march lower in the coming months could buy a Dec 37-32 put spread for $2.60. The max loss is capped at $2.60 and will be incurred if VXX sits above $37 at December expiration. The max reward is capped at $2.40 and will be captured if VXX falls beneath $32 by December expiration.

At the time of this writing Tyler Craig had no positions in any securities mentioned here.